Real Estate Insights

Continental European real estate market commentary: Q3 2019

The eurozone is currently a two-speed economy.  The slowdown in world trade and investment has hit manufacturers and output has fallen by 1% since late 2018.  Conversely, the services sector continues to grow, supported by solid labour markets, rising consumption and government spending.  The risk is that the downturn in manufacturing deepens, possibly because of a disruptive Brexit or a further escalation of the trade dispute and then spreads to the services sector.  The European Central Bank (ECB) has begun to loosen policy, but its room to manoeuvre is limited, given that the main financing rate is already at zero.  Low borrowing costs for government provide some room for government stimulus. Schroders forecasts that eurozone GDP will grow by 1% p.a. through 2019-2020.  Sweden, France and Spain will probably see faster growth, while Germany which has a relatively large manufacturing sector, is likely to lag behind. 

The fall in office vacancy has slowed sharply this year, as demand has eased in step with the economy and as development has increased.  As in many markets, vacancy of quality space in key inner city markets has virtually run out. At 6.4% the average office vacancy in major European cities in mid-2019 was only slightly lower than at the end of 2018 (6.7%).  While this could mark a turning point, we think that office rents are unlikely to fall in most cities given that developers and lenders are generally cautious and new building is low by historical standards.  We expect office rental growth to slow, but remain positive through 2020-2021, assuming the eurozone avoids a recession.  Our forecasts suggest that Berlin, Madrid and Munich will see the biggest rise in average grade office rents over the next two years of 3-4% p.a., but most other cities will see rental growth of 1.5-2.5% p.a.  The main exceptions are Milan and Warsaw where there is a risk of over-supply.      

Despite a fall in lettings to manufacturers this year, overall demand for warehouses in continental Europe remains strong.  Online retailers (e.g. Amazon, Zalando) have continued to expand and traditional retailers (e.g. Decathlon, IKEA) are also taking more space to support their online sales.  In general, the growth in demand has been matched by supply and while there is a shortage of land for big warehouses around Hamburg, Munich and Rotterdam, occupiers have typically been willing to pre-let developments in smaller cities, provided they have an adequate labour force and good road connections.  In the first half of 2019 two-thirds of logistics take-up in Germany was outside the big seven cities.  As a result, rental growth in the logistics market has been limited to around 2% p.a., although some smaller warehouses, which are used for last mile deliveries in cities and where supply is more constrained, have seen stronger rental growth.

Demand for retail space in continental Europe is weak as retailers adapt to growing online competition and fewer shoppers in their stores.  While total retail sales in France and Germany could grow by 2-3% in 2019, store sales are likely to shrink.  Several retailers have failed and even successful retailers like Inditex have closed more stores than they have opened over the last 12 months and use the weakness of the sector to renegotiate lease terms.  In general shopping centres have been most affected, as hypermarkets have cut their non-food sales areas and clothing retailers have contracted, but the number of empty shops in city centres is also rising.  We expect that prime shopping centre rents will fall in most European cities over the next three years and that prime shop rents will stagnate.  The most defensive retail types are likely to be convenience food stores and out-of-town retail warehouses with affordable rents.

Although the total value of transactions in continental Europe has fallen by 5-10% from its peak in 2017 (source: RCA), most of the decline has been in the retail sector.  The sharp fall in bond yields since March means that competition among investors for non-retail assets is likely to remain fierce.  German open-ended funds are seeing high inflows and the uncertainty over Brexit has encouraged US and Asian investors to favour the continent over the UK.  We expect that office and industrial yields will fall by a further 0.25% over the next 12 months and that yields on hotels and other types are also likely to compress.  The downside is that this leaves capital values more exposed to any future rise in bond yields.  Shopping centre yields will probably increase by 0.5-1.0% over the next 12 months, as investors price in lower rents.

In the office market we currently see most value in either re-development projects in central business districts, or in stabilised assets in adjacent areas where yields are higher.  In the industrial market we favour multi-let estates and smaller distribution warehouses where it is still possible to buy good assets on yields of 5%, or higher.  We also see value in hotels with management agreements.  We are cautious about most retail assets, because we do not believe that current yields reflect the risks of higher vacancy and falling rents.   


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